Many of the products you use everyday, like your CD player and TV set,
were not designed or manufactured in the United States. Why do you ^
have the opportunity to buy and use so many foreign products?
Story by Cedric fan
Revised by Steve Malin
and Radhika Mithal
Art by Jesse Chen
The reason is that the United States
trades goods and services with many other
nations. Trading practices have changed greatly
over the years, so we ll start this story
by looking at trade history.
After stagnating for several
i hundred years, the volume
* of foreign trade increased
of foreign trade increased
rapidly in the early 1 500s.
The European nations, dominant at that
time, pursued an economic philosophy
called mercantilism. Mercantilism
consisted of two main ideas. The first
was that precious metals determined
a nation's wealth*
^ All that gold in the new ^
world is providing yet another
golden opportunity to increase my
wealth, I can hardly wait for the
* California gold rush to start
300 years from now* 4
We must find new foreign
markets for our products so
that our supply of gold and
silver will increase*
The second mercantilist idea, directly
related to the first, was that countries
should export more than they import.
During the mercantilist era, exports
were sold for gold and silver, so a
nation exporting more than it imported
would continuously increase its wealth*
^ You seem to havens
extra time on your hands
To export more than they import, mercantilist nations
focused on finding new natural resources that could be
processed and manufactured into goods fit for sale abroad*
of Adam Smith’s
The Wealth Of
Nations in 1776,
r As I say in my book,
the expense of acquiring an
unnecessary quantity of gold
and silver will diminish the
actual, or potential,
V wealth of a nation, >
Smith did not share the mercantilists 1 belief that a country^
wealth was determined by precious metals. He believed a
nation s wealth ultimately was determined by its holdings of
assets, such as household items that consumers desired.
Smith argued that nations should export
the surplus of what they were best at
producing, and use the proceeds of the
export sales to import what they were less
good at producing. Only then would the
true wealth of nations increase.
Smith pointed out that many nations have natural and acquired advantages in producing
certain goods. Some countries are rich in natural resources, such as lumber and farmland,,..
... and others in acquired resources, such as a highly
trained workforce and a large technology base. These
countries have an advantage In producing goods such
as silicon chips, because chip manufacturing requires
skilled workers and technologically advanced machines.
These natural and acquired advantages
ted Smith to introduce the principle
of absolute advantage.
A country has an absolute
advantage in the production of a good or
service when it can produce that output more
cheaply than any other country, if countries
specialize in producing the good in which they have
an absolute advantage, they can trade what they
don't need and be better off economically.
Smith's ideas on trade were
refined in the early 19 th century,
when the wealthy bond trader,
David Ricardo, explained the concept
of comparative advantage.
wasn't quite right,
it’s not absolute
really matters, but
■B*" If two countries have different j
f resources and skills, they will have different^
relative abilities to produce different goods. ^
Both countries will be better off by specializing
in what they produce most efficiently and trading
what they don’t need domestically, ,
Ricardo showed that when two nations have
different relative abilities to produce
different goods, trade will benefit both nations.
A simple example will illustrate the concept of
comparative advantage. Let's assume that the
United States and a mythical country we'lL call
Jean stand both produce blue jeans
and compact discs. .
Now, suppose it takes 1 hour
to make a CD and 2 hours to
make a pair of blue jeans in the
United States, while it takes 4 hours
to make a CD and 4 hours to make
a pair of jeans in Jeansland.
HOURS PER GOOD
1 PAIR JEANS
Note that the United States has an absolute advantage
in producing both goods. That is, it takes the
United States fewer hours than Jeansland to manufacture
either a pair of jeans or a CD.
Because the United States has an absolute advantage
in producing both goods, you might think that only
the United States would benefit from trade. In fact,
both nations will benefit from trade because
Jeansland and the United States have different
relative abilities to produce CDs and jeans.
Jeansland and the United
States will benefit onLy if
they produce different goods
~ 1 I -
Since it takes 1 hour to make a CD in the United States and A hours in Jeansland, U.S. workers are four times as
efficient as Jeansland workers in making CDs. Because it take 2 hours to make a pair of jeans in United States and
A hours in Jeansland, U.S. workers are only two times as efficient as Jeanstand workers in making jeans. Thus
we say that U.S. workers are relatively more efficient in the production of CDs than in the production of jeans.
Alternatively, because it takes 4 hours to make a pair of jeans in Jeanstand and 2 hours in the United States, Jean stand
workers are Vi as efficient as U.S, workers in making jeans, and because it takes 4 hours to make a CD in Jeansland and
1 hour in the United States, Jeansland workers are only % as efficient as U.S. workers in making CDs. Therefore,
Jeansland workers are relatively more efficient in the production of jeans than in the production of CDs.
- Since Jeansland is relatively ^
more efficient in making jeans,
Jeansland has a comparative advantage
in the production of jeans. .
^ Because the United States
is relatively more efficient
in producing CDs, the United States
has a comparative advantage in
v the production of CDs,
I Wh ATidid
Comparative advantage can also be
described in terms of opportunity costs
An opportunity cost is what you give
up to do something else.
Opportunity cost is the basis of comparative advantage.
To see how, suppose U,S, workers at first produce
only CDs. Producing T CD fewer frees 1 hour,
with which an American can make Yi pair of jeans.
Because the opportunity cost of making a CD is lower
in the United States (1/2 pair of jeans) than in
Jeansland (a full pair of jeans), Americans have
a comparative advantage in making CDs. Similarly,
Jeansland has a comparative advantage in making
jeans* Can you figure out why?
jeans, I can save some of my income
and buy jeans imported from Jeansland*
However, my plan won’t work unless
workers in Jeansland choose to make jeans.
That’s right* Jeansland has a comparative advantage in
making jeans because the opportunity cost of making
a pair of jeans is lower in Jeansland (1 CD) than in
the United States (2 CDs)*
If Jeansland er$ trade jeans for CDs
they're trading the good they can produce
relatively more efficiently for the good
they produce relatively less efficiently*
This must be better than the initial
situation, in which Jeansland produced
both goods. Likewise, the United States
must also be better off under trade
based on comparative advantage.
If all nations exploit their comparative advantages, alt will be better off and the standard of living of
each nation will rise. Gross domestic product (GDP), the value of goods and services produced in a country,
will increase and new jobs will be created in industries that have a comparative advantage.
It should be noted that the ^
Jeansland /United States example
is a great simplification of what
happens in the real world. >
Thus, our example yields
valuable insight into the
reasons nations trade.
In the real world, countries never
completely specialize in the production
of one or a few goods, but underlying
economic factors related to comparative
advantage do lead to concentration in
the production of certain goods.
The important point is that
countries are better off when they
exploit their comparative advantages*
What happens, though, when
countries nave trade barriers?
♦ * v
Two types of trade barriers are tariffs and quotas.
A tariff is a tax imposed on goods imported into a country.
For example, the United States might Impose a St tariff
on all bottles of French wine entering the United States...
I believe in trade.
A quota is a restriction on
the quantity of a particular
good entering a nation.
Most economists oppose
tariffs and quotas because
they limit free trade.
Free trade, in turn, raises
standards of living when
countries lower their trade
particularly in countries with
l developed economies
— I I
Several blocs of nations have attempted to lower trade barriers between their members. For example, Mexico, Canada,
and the United States ratified the North American Free Trade Agreement (NAFTA) in 1993, sharply reducing tariffs and
easing quotas on goods and services traded within the bloc. Another bloc that has done this Is the European Union (EU).
3. UNITED STATES
4. CZECH RfRfiLC
On a broader scale, the World
Trade Organization (WTO), created
in 1995 by the Uruguay Rounds of
negotiations, promotes free trade
and works to lower trade barriers
In all nations simultaneously. The
WTO serves as a forum for its 146
member countries to establish,
negotiate, and monitor trade
There are some reasons why countries might
elect not to remove all barriers. One is that
countries want to have domestic suppliers of
products vital to national security, so they
won't have to rely on foreign suppliers
So, you're >
telling me you need
trade barriers until
ou're well established
Yes, we haven't had
time to work out all our
Another is that many countries want to develop their new and
struggling industries. Some people say that these new industries
need the protection of trade barriers in order to mature
into industries able to compete in the world market.
A third reason is that white free trade
tends to make a country as a whole
better off, this doesn't mean that all its
population will be made better off. When
countries specialize in production according
to comparative advantage, some workers
will lose their jobs. Inis will lead to
temporary, or possibly permanent,
unemployment for some people.
Returning to our United States /Jeansland example: if, suddenly,
Jeanslana CD makers lose their jobs because of competition from
the United States, and U.S. jeans makers lose their jobs because of
competition from Jeansland, there might be some unpleasant
short-term problems if the workers carft be retrained quickly
for new jobs in a different industry.
The displacement of workers can constitute
a political and economic problem. This is a —
major reason why no nation is calling for an i I
tifMrlfl rtf all traHa karriar* ^
immediate lifting of all trade barriers.
To minimize the hardship on workers, countries
lower trade barriers slowly, so that with enough
time, workers can be retrained for new jobs and
of free trade.
f —and the Labor Department reported^
today that unemployment is inching down.
In related news, the Commerce Department
i reported that incomes continued a
their upward trend.
So far, we ha vent discussed how trade actually
takes place. We have simply assumed that countries
would specialize In what they are relatively most
efficient at ofoduoinc. and then somehow trade.
But countries don’t usually trade items
for other items. For example, a United
States exporter of compact discs wants
to be paid in U.S. dollars, not blue jeans.
To examine how countries actually trade goods and services, we
lave to introduce money. Most countries have their own currency. £
The United States has tne dollar, Japan, the yen. Some countries I
have a common currency, such as the euro. £
One currency is traded for another in the foreign exchange market.
This market is a network of foreign exchange dealers, mainly in
large financial centers, who buy and sell various currencies.
Wow! Some '
Dole have a yen
for trading! j
Over $1.5 trillion are traded
daily in foreign exchange
Foreign exchange dealers, linked by
telephones and computers, stand ready
to list prices at which they wilt buy
and sell different currencies.
The dealers earn profits by buying
currencies at one price and selling
them at slightly higher prices-
sal PESOS AT;
The difference between
the price of 10.90 pesos
and price of 1 1 .20 pesos
is my profit.
For example, white a dealer might
be willing to pay 10*90 pesos per
dollar, the dealer might ask for a
price of 1 1 ,20 per dollar from
someone wanting to buy dollars.
The rate at which one currency is traded for another is known as the
exchange rate. An exchange rate listed in the United States is usually
expressed in terms of how many units of a foreign currency one U,S, dollar
can buy. The Mexican peso exchange rate, for example, might be 10,9
pesos per dollar. Exceptions include the euro and the U,K, pound sterling,
which are expressed in dollars per unit of these currencies.
Large corporations, financial institutions, and government
agencies need to trade large amounts of currencies on a
regular basis, either for themselves or (in the case of the
financial Institutions) for their clients.
f In contrast, individuals^.
f and small companies, who \
have smaller foreign exchange
needs, operate in a retail
environment. As with any retail
service, they have to pay a
somewhat higher price. In other
. words, they receive a less J
favorable exchange rate. /
A tourist, for example,
currency at a financial
institution, typically a
The bank is
offering the tourist a
The reason the retail foreign exchange (FX, for
short) customer gets a less favorable rate is that retail
transactions are usually small and involve paper
currency, rather than electronic money, so they're
relatively expensive to execute.
could execute a dozen
electronic FX transactions
for much larger sums.
MHjMamifc \ \n
To understand why foreign exchange is important,
suppose you're atouristina foreign country* say*
Mexico. You get off the plane and head to a nice
restaurant because you're hungry.
How do you do it? U.S. dollars
wont work; the restaurant
wants 300 pesos.
Fortunately, you had changed dollars
into pesos at the airport bank, and
you can pay for your meal.
What happens if you use a credit card to
pay for your meal? Because the credit card
company is located in the United States, your
monthly statement will show the amount
owed for the Mexican meal in U.S. dollars.
As is the case with any credit
card transaction, you don't pay the
restaurant; rather, your credit card
company is lending you pesos to
pay for the Mexican meal. As a
convenience for you, it will convert
the pesos into dollars, and show
the dollar amount owed on
your billing statement.
How 3 m I
going to pay for
Some transactions simply take place
are guessing that the currency they're
over the short run and they can sell
buying will appreciate
it later for a profit.
import goods also
need to exchange
currency. A U.5. car
Japanese cars has
to find a way to
pay the Japanese
for the cars.
Most FX transactions take place because
people in one country want to buy real
and financial assets in another country.
The Japanese manufacturer wants to be
paid in yen. not dollars, so the U.5.
dealer has to find a way to convert some
dollars into yen to pay for the car shipment.
Now that you know why
the foreign exchange
market is so important, we
can describe the two primary
types of transactions that
take place in the market.
An immediate currency
exchange is known as a spot
transaction. A transaction
arranged to occur at some
future date at an exchange
rate agreed upon
today is known as a
To understand the usefulness
of forward contracts, we can
use the U.S. importer of
Japanese cars as an example.
Suppose that the importers
next shipment of cars is due
in one month.
To pay for the cars, the U.S. importer must find a way to pay the Japanese car maker in yen in one month.
Suppose that the exchange rate is now 120 yen to the dollar and each car costs 3 million yen. How many
dollars is this? We compute as follows: (3 million yen) x (SI/120 yen) * $25,000.
Now suppose that a month later the exchange rate is 100 yen per dollar. What does this mean? At an exchange
rate of 120 yen per dollar, $1 will buy 120 yen. At an exchange rate of 100 yen per dollar, $1 will buy 100 yen.
Because the dollar buys fewer yen at the new exchange rate, we say that the dollar has weakened, or depredated.
! TOP AY:
3 MILLION YIN
Because the dollar has weakened, it now
takes more dollars to equal 3 million yen.
How many more? The new exchange rate is
100 yen per dollar, so 3 million yen will be worth
(3 million yen) x ($1/100 yen) = $30,000.
Thus the car is $5,000 more expensive in
dollar terms than it was a month ago.
3 MILLION YEN x
Of course, the reverse could also happen. The exchange
rate might increase to 150 yen per dollar. In this case,
we say the dollar has strengthened, or appreciated, against
the yen, because $1 now buys more yen than before. The
precise dollar amount of the change is computed as follows:
(3 million yen) x ($1/150 yen) ® $20,000, a decrease of $5,000,
3 MILLION YEN x
$ 1 &
The importer faces exchange rate risk,
because in a month, the 3 million yen might
be worth more or less than the current
$25,000. This uncertainty makes it difficult
to make a business plan.
I can't know for sure how
many cars ill want to import
unless ! know what the price
will be in dollars.
You might wonder why the U.S. importer wouldn't just
prepay for next month's car shipment at today's exchange
rate of 120 yen per dollar. That would obviously eliminate
uncertainty and reduce the exchange rate risk. One reason
is that companies generally prefer to keep their money
for as long as possible to earn interest on it.
Besides prepaying, there's another
way the importer can eliminate
uncertainty. The importer can arrange
a forward contract and Took in" the
exchange rate so that the importer's
cost of cars in dollars will be fixed.
Now that I ve locked in
my exchange rate, I know
precisely how many dollars
the car shipment will cost.
To illustrate a forward contract,
suppose that the 30- day forward
exchange rate is 125 yen per dollar.
Because the car importer has access
to forward contracts, the expected cost
of the 3 million yen needed to pay the
Japanese car maker In one month is 524,000.
FOREIGN EXCHANGE RATES
(UNITS OF FOREIGN CURRENCY PER SSJJ
/ I BRITISH
f / P011AR
/ EURO 1
I 0.91 |
I JAPANESE 1
1 SWISS f
^ I'm better off holding ^
dollars than yen for the next
month because Interest rates are
higher in the United States
L than in Japan. >
One factor affecting forward exchange rates is
I that Interest rates differ between countries,
so people who hold the currency of a country with
1 high interest rates can earn a higher return.
Indeed, if interest rates are higher
in the United States than in Japan, the
likelihood increases that the dollar will
strengthen relative to the yen.
Other factors such as inflation
expectations and economic
conditions of a country, influence
the value of its currency.
the exchange rate
increases or decreases, it won't
affect the importers purchasing
costs, since his exchange rate has
already been determined in the
V forward contract. >
/ The car importer has H 'V
r managed to reduce his >
business risk because he knows
with certainty how much
s. the cars wilt cost in one J
V month's time,
The U,$. importer may arrange a forward contract through
a large bank. The bank agrees to sell 3 million yen to the
U.S. importer, in one month's time, at a forward exchange
rate of 1 25 yen per dollar The import company is effectively
paying the bank to assume some of its exchange rate risk.
You should keep in mind that forward exchange
rates are not precise forecasts of future exchange
rates. Therefore, locking in a forward exchange
rate creates some risk for a company because
it may have locked in an unfavorable rate.
r I would have ^
done better by waiting
to buy the yen, j
] PRICE: Si%ooo
For example, if the actual exchange rate in one month is higher
than 125 yen per dollar, the U,S. company would have benefited
by not entering into the forward contract because the price per
car is now less than 524,000.
IFXT Tf uS
Some monetary authorities (central banks and finance ministries) are also actively
involved in the foreign exchange market. They try to maintain stability in the marketplace
for currencies, so that international trade can take place unimpeded.
The monetary authorities of countries whose currencies aren't
traded in targe quantities in the FX market can directly
affect supply and demand conditions for the currencies.
The krown has been ^
falling in value. Let's
buy some krowns to pump
. up its value. .
For a country such as the United
States, whose currency is actively
traded in the FX market, central
bank FX intervention is more likely
to influence market sentiment
than to alter demand and supply
conditions for the dollar.
Although there is
no absolute rule
sharp and rapid
to underlying economic
signs that the central
banks might take action.
r offer for the \
r forward rate is f 05 yen
per dollar? i think a
more realistic forward
rate is 1 10 yen per dollar* *
Let’s wait until things
L settle down in the
foreign exchange A
A disorderly foreign exchange market can lead to
economic instability. With increased fluctuation in
exchange rates, it becomes more difficult and expensive
to agree to market transactions, and companies
may be unwilling to make commitments in foreign
currencies. As a result, trade can suffer.
* And that, 1
we hope will put
on the dollar
V the euro. A
The world's major central banks sometimes
combine efforts to try to maintain stability
in the foreign exchange market*
8 So, we agree that the value of the
dollar is dropping too sharply against the euro,
and that we should do something to remedy the
situation* We can try to do that by selling
NOV. 1 1
Foreign trade and exchange are growing rapidly* For
example, U.S* imports of goods and services now equal
almost 17 percent of the annual output of the U.S*
economy, almost three times the percentage of 35 years
ago. International trade will continue to grow rapidly as
markets become more global, and the growth of trade will
continue to raise living standards in most of the world.
For more information about
New York Fed education
Federal Reserve Bank of New York
Public Affairs Department
33 Liberty Street
New York. NY 10045
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